Tuesday, October 09, 2007

Interest rate mechanism

These notes by Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco, say there is a question about how exactly interest rate reductions by the Fed impact consumer spending, and the broader economy.

Now let me return to the national economy. Beyond the housing sector’s direct impact on GDP growth, a significant issue is its impact on personal consumption expenditures, which have been the main engine of growth in recent years. Indeed, data on consumption spending in the last few months have continued to show strength. The nature and extent of the linkages between housing and consumer spending, however, are a topic of debate among economists. Some believe that these linkages run mainly through total wealth, of which housing wealth is a part. Others argue that house prices affect consumer spending by changing the value of mortgage equity. Less equity, for example, reduces the quantity of funds available for credit-constrained consumers to borrow through home equity loans or to withdraw through refinancing. The key point is that, according to both theories, a drop in house prices is likely to restrain consumer spending to some extent, and this view is backed up by empirical research on the U.S. economy.

A friend of mine at Chicago told me that MEW was the primary mechanism by which lower interest rates contributed to increased consumer spending.